A “qualified personal residence
trust” or “QPRT” is a special type of grantor trust
specifically authorized by the Internal Revenue Code. The trust is
created by an individual (the "grantor"), and funded with with a "qualified
residence." The grantor retains the right to use the residence for
a term of years (or possibly for the grantor's life). In order to
qualify as a QPRT under current tax laws, the trust must be irrevocable.
When the trust ends, the assets pass to someone other than the grantor
- usually the grantor's family members (i.e., his or her heirs).

Qualified Residences

What can you put in a QPRT? According
to the Treasury Department regulations, a principal residence and one other
residence (including a vacation home) can each qualify as a “personal residence.”
Thus, every grantor has the ability to create a maximum of two QPRTs. Married
couples who share the same principal residence may create three QPRTs without
violating this rule, one to hold the shared principal residence and two
others created separately by each spouse to hold a second and third home.
Adjacent land reasonably appropriate for residential purposes also qualifies
for transfer to a QPRT, as do appurtenant structures used for residential
purposes (such as swimming pools and tennis courts). The fact that a residence
is subject to a mortgage does not affect the residence’s qualification
for transfer to a QPRT, nor does the fact that part of the residence is
used for a home office or the fact that a portion of the property is leased
to someone unrelated to the grantor, provided the property continues to
remain the grantor’s personal residence.

The regulations restrict QPRTs from
holding any other property (for example, household furnishings) except
for limited amounts of cash. Any cash in excess of that needed for trust
expenses (including mortgage payments), contemplated improvements or the
purchase of a personal residence, all to be paid within six months, must
be distributed out of the trust and back to the grantor.

If the grantor wants the trustee
to sell the residence held in the trust, that can be done, but only if
another residence is going to be purchased by the trustee within two years.
If the trustee sells the residence, the trust may have the benefit of the
Internal Revenue Code provision that allows the exclusion of gain on the
sale of a principal residence (up to $500,000 for married individuals filing
jointly and $250,000 for other individuals). If the grantor stops using
the property in the trust as a personal residence, then the trust must
terminate and the property must be distributed out of the trust and back
to the grantor (or, alternatively, the trust must be converted into a “grantor
retained annuity trust” — or “GRAT”).

Unlike the traditional trust where
the income beneficiary receives distributions of income generated by the
trust property, with a QPRT the grantor retains the right to use the property
during the trust term. At the end of the term, the grantor should be prepared
to give up use of the residence since the remainderman will then be its
legal owner. If that is not acceptable, the grantor might then arrange
to rent the property from the remainderman at fair market rental value.
The right to rent the property can also be granted at the outset when the
trust is created and made a part of the terms of the trust agreement.

Gift Taxation

When a grantor trust such as a QPRT
is created, the grantor has essentially split the trust into two pieces:
(1) the grantor's right to use the residence for a period of time (the
"term") and (2) ownership of the residence after the term ends (the "remainder").
Since the trust is irrevocable, the grantor has made a gift of the remainder
which is subject to all of the usual tax rules governing gifts (see the
Lifetime
Gifts webpage). A gift tax return
must be filed. For most QPRT's, any resulting gift tax will be offset
by the grantor's unified credit (currently
sufficient to completely shield cumulative gifts up to $5,450,000) (2016).
However, since the recipient must wait until the end of the trust term
to receive the remainder, the present value of the remainder is
less than the value of the trust property -- for the same reason that a
dollar is worth more today than it is ten years from now. Subject
to some important exceptions discussed below, when the recipient eventually
receives the remainder, there are no additional gift taxes, even
if the trust property has appreciated. In essence, a QPRT will freeze
the value of the residence for transfer tax purposes on the date the trust
is created.

Here's an example of how the gift
tax operates on a QPRT: Bob, a 60-year-old, transfers his $600,000
residence to a QPRT and retains the use of the residence for 10 years.
At the end of the ten year term, the residence will pass to Bob's
children. According to the IRS, the present value of the remainder interest
in the residence is $206,000. If Bob lives for ten years or more,
he will no longer own the residence at his death, and no additional
transfer taxes will be owed. The only transfer tax will be on the
$206,000 gift -- and this tax is completely sheltered by Bob's unified
credit. If the property appreciates at 5% annually, his children
will receive a residence worth over $1 million -- free of all transfer
taxation.

In each particular case, the value
of the taxable gift will vary depending on such factors as the length of
the trust term and the grantor’s age. The tax savings will depend on the
size of the grantor’s entire estate and other factors. Since the
top marginal estate bracket could be as high as 35%, the transfer tax advantages
of this type of trust are obviously significant.

Estate Taxation

In order for a grantor to reap the
tax benefits of QPRT, he or she must survive the term of the trust. If
the grantor dies during the trust term, for estate tax purposes the full
value of the property is brought back into the grantor’s gross estate.
In this event, however, the grantor is simply left in the same situation
as would have existed had the trust never been created. That being the
case, there really is no risk or downside to creating a QPRT and, as noted
above, the tax savings can be significant if the grantor does succeed in
surviving the trust term.